When setting up a business, conventional wisdom dictates that the business be set up in a legal entity providing limited liability protection, like a Limited Liability Company (LLC). This is true too when a business wants additional capital by allowing investors to participate as equity owners in exchange for that infusion of cash to the business. But the business owner should be forewarned: the complexity of any business endeavor is infinitely more complex when other people are included in the ownership pool.
The simplest way to set up and run a business is to have just one owner (in most cases, I count a married couple as one owner because their interests are usually so closely aligned). In setting up a one-owner LLC, the process is straightforward as is the documentation needed. A person setting up an LLC this way can usually opt for boilerplate LLC organizational documents that don’t need much in the way of customization. Why? The sole owner has unilateral authority to change the business any time he or she chooses. In effect, the owner is not bound by any enforceable provisions in the entity that preclude the owner from making any conceivable decision for the company. It’s simple.
Introduce just one more owner and the calculation is vastly different. With all due respect to the TV shows that popularize the concept of equating complete control to 51% ownership, that is just not the case, and it is naïve to rely solely on default controlling ownership rights.
Take the example of an LLC owned 60% by Fred and 40% by Julie. Let’s assume that Fred exercises his authority to declare that the LLC should purchase assets (maybe inventory or land). To obtain the necessary financing, the bank might require all owners to sign the loan agreement in their personal names (this would be customary for a small business loan). Without addressing it in a customized agreement, the default is a 60% owner of an LLC can never compel the 40% owner to offer a personal guarantee. Therefore, the 40% owner effectively has veto power.
Similarly, a buyer might offer to buy the entire business in a transaction paying 10 times the true value of the business in an LLC ownership sale…but only if the buyer can buy 100% of the company. Here too, the 40% owner can effectively veto the sale.
More important than simplistically saying that one owner is “in control” and the other is not, there are a host of issues that should prudently be discussed and agreed upon (in writing) before the decision is made to go into business together. Often these agreements are contained in the Operating Agreement but can also be placed in a separate agreement among the owners.
Continuing with the example of Fred and Julie – assume further that Fred and Julie own a landscaping business and Julie provided money to the operation (investor) and Fred runs the business. Though Fred is “in control,” are there issues that he would want to shore up in addition to those outlined above? Indeed, there are many. Often business owners want to keep key business information and trade secrets confidential. Perhaps Fred and Julie then must agree to keep all business information confidential. Can Julie sell her interest in the LLC to a competitor (or anyone else)? Without addressing it in a customized agreement, Julie can sell to whomever she chooses.
Are there issues that Julie would want to address to feel more comfortable with her investment? Absolutely. Imagine Fred buys his fertilizer and pesticides from his brother – they cost a bit more, but it stays in the family. Should Fred be required to disclose this, or perhaps should he be prohibited from engaging in any transactions that personally benefit him or his family? Can Fred start a competing landscape company? Can Julie? Can Fred singularly choose when and how much of the profits get pushed to the owners or can he unilaterally choose to use the funds to facilitate growth (or increase his own salary)? What if Julie owes taxes on the business’s profits but doesn’t receive any distribution to even cover the taxes?
Sometimes owners want to include family members in the business. Is Fred or Julie within their rights to demand that his or her child be employed at the landscaping company? What about Julie…should she be able to work for the company? Remember the distinction between ownership and authority. The two need not go hand in hand. A person can own stock in Microsoft but have no right or obligation to work for the company.
This article just skims the surface of planning opportunities when setting up an LLC with another person. There are many more issues to discuss and many ways to address each. Work with an experienced attorney to plan for items like those mentioned here…and many more.
Note: for simplicity’s sake, this article only discusses LLCs. There are other forms of doing business as an entity to include Limited Partnerships, Corporations, Sole Proprietors, and General Partnerships. Still any entity with more than one owner faces similar challenges.
The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.